Trend Trading Conclusions – Buy High, Sell Low

- 09 February 2011

In the last few MarketPulse articles prior to the break we discussed the concept of trend trading. To recap, trend trading involves always investing our money in the same direction as the prevailing trend in prices. Rather than trying to ascertain the value inherent within a security, and then comparing it back to the current price to determine whether the security is cheap or expensive, we suggested relying mainly on charts to pick prospective investing opportunities. The charts would help us identify both up and down trends and we would invest accordingly.

We left off last year by busting a couple of the big myths in the markets including:Myth 1 – The prevalence of ‘Blue Chip’ stocks, and Myth 2: The market goes up in the long run. We noted that it is foolhardy to invest one’s money in a company based upon the assumption that because it is big, and potentially has a well known brand, that it is therefore a very good investment. Too many times in the past household names have gone to the share market wall and investors have been left scratching their heads. Next we noted that whilst the market might appear on paper to go up in the long run, it was extremely dangerous for investors to assume that as a result of this their portfolio would also go up in the long run.

This week we would like to have a go at busting the final bug myth in investing which causes novice traders to lose money time and again. This is: Myth 3 – Buy low and sell high. This is possibly the hardest one to bust because it seems so intuitive to most. However, it is this obsession with buying stocks which have fallen in price, and selling or avoiding those which have risen strongly which is the single biggest contributor to the average investor failing to meet their investing goals.

Surely it makes more sense to buy stock when the price is low than it does when the price is high? Most investors would argue that there’s no point waiting until something is trading at its all time highs to buy. Why not buy it when it is cheap. Then one can sell it at those all time highs when it is expensive.

The best way to explain how this thought process is going to be destructive to the accumulation of wealth in the markets is to use the analogy of buying bananas. Most would agree that it makes more sense to buy bananas when they are on special, say for 99 cents per kilo, rather than deferring that purchase until next week when they will be back at their pre-sale price of $2.99 per kilo. In fact, one would expect that it makes plenty of sense to ‘load up’ on bananas this week to last us through next week and potentially until bananas are again on special.

I completely agree that this makes sense for bananas. For shares however, it is downright dangerous. This mentality of ‘load up when it’s cheap’ is going to ensure that the investor buys stocks which are in distress or worse – on the verge of complete collapse. Stocks which have fallen in price have done so invariably for very good reason. Investors who know better are selling those shares in earnest to avoid further losses. The situation for these companies is akin to a burning building with everyone pouring out of the exits. For an investor to buy now is the same as wondering into the burning building thinking everything is just fine. An investor who does so is going to get burnt!

Shares in companies aren’t bananas. Whilst bananas may well be cheap at 99c, that stock which has fallen from $5.00 to 99c most likely isn’t. In fact, it’s likely to be stillexpensive.

Stocks which are cheap are the ones which everyone is buying and nobody is willing to sell. Now, let’s think of this for a second – everyone is buying and nobody really wants to sell…This would mean that there’s plenty of demand for the stock and not very much supply. Economics 101 tells us that any stock which is experiencing great demand for its shares and little supply will see the price of its shares rise. The greater the demand and the lesser the supply, the greater will be the increase in the price. These are the stocks we really want to buy.

Following the above, stocks which are showing significant price appreciation are not expensive at all. The price appreciation is a result of greater demand than supply because investors in the market think that the stock is cheap (why else would they buy so fervently and be so reluctant to sell?). They are likely to continue to do so (the trend) and continue to push the price up. If our goal is to buy stocks which have the greatest chance of rapid price appreciation, it therefore makes sense to identify stocks which are already in well defined uptrends and further still, in steep upward moves.

If this seems crazy to you, then you are still thinking like a bottom-fisher! Think about each time you had the choice between two stocks, one which had fallen significantly and appeared to be ‘blatantly’ undervalued, and one which had shot through the roof and was ‘clearly’ overpriced. Let’s say you did the ‘logical’ thing and bought the ‘undervalued’ stock. A few weeks later how did things turn out? Let me guess, the ‘undervalued’ stock you bought had gone nowhere or worse still had declined even further (even cheaper now – better buy some more!!), and the stock you refused to buy because it was so ‘overvalued’ has become a hell of a lot more so!!!

“Oh, that’s not fair! I must be the unluckiest investor in the world!” you exclaim. “This always happens to me”.

Well it makes sense that if you have a flawed approach, such as trying to buy low and sell high, then you will get a flawed outcome. Similarly, if you continue to stubbornly persist with this flawed approach, then you will soon find that you will get the same flawed results time and again over a long period of time. Don’t worry – the vast majority of novices start out this way. If this sounds like your investing approach then there is still hope!

The professionals understand that if they were to buy a stock which had fallen significantly in price, then the result is that the stock is most likely in a downtrend. By buying such a stock they are fighting the prevailing trend – a big no-no. Rather, they would prefer to find a stock which has appreciated rapidly in price and purchase this one as it is most likely in a prevailing uptrend. By simply following the trend they are giving themselves the greatest probability of success. Similarly, if they were to turn around and sell a strongly performing stock, they would be fighting the uptrend. So rather than sell out, the will choose to hold on and ride out winning positions as long as possible. It is this tendency to pick strongly performing stocks, and ride out one’s winners which ensures that these professionals outperform the ‘mum and dad’ investors consistently year in-year out.

In conclusion, investors should review their current investing approach to determine whether they are also one of the bottom fishers who try to buy ‘cheap’ stocks in the hope that these stocks go back up. If this is the case, then one seriously needs to reconsider their approach in order to have the greatest chance of picking next year’s big winners and avoiding the usual raft of big losers. Finally, professional investors avoid the ‘buy low and sell high’ approach and rather choose to ‘buy high and sell even higher’. When a stock is in a downtrend, they will short sell the stock and in effect ‘sell low and buy back even lower’. Once again the successful professional trader acts in complete opposite to the novice punter…but that makes a lot of sense doesn’t it!

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